Bitcoin: Is It A Bubble Or A Good Investment?

“Examine the record of history, recollect what has happened within the
circle of your own experience, consider with attention what has been
the conduct of almost all the great unfortunate, either in private or
public life, whom you may have either read of, or heard of, or remember;
and you will find that the misfortunes of by far the greater part of them
have arisen from their not knowing when they were well, when it was
proper for them to sit still and be contented.”

—Adam Smith
The Theory of Moral Sentiments

“There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”

Charles Kindleberger

In a world of low returns, increasing inequality, widespread mistrust of governments and regulatory agencies (more so since  2008), an alternative has appeared that seemingly allows anybody to get rich while giving the middle finger to the bankers, financial middlemen, central banks and non believers out there.

Of course, I am talking about the Bitcoin craze.

Some people have recently made very high returns in record time from owning Bitcoin and naturally that attracts widespread attention. Virtually everybody prefers being richer to poorer, and working less to working more…

Therefore, It Is Understandable For People To Want To Put Money Into Bitcoin…

According to wikipedia, Bitcoin is a decentralised digital currency with no intermediary (such as a bank or government) meaning transactions take place directly between users. A public ledger called the blockchain records Bitcoin transactions.

What is Bitcoin? Is it a currency, an asset, a payment mechanism or a new and easy way to speculate?

If it is a new currency, who’s to say it will stick? There are hundreds of new cryptocurrencies out there with more being created constantly. A currency needs to act as a store of value and to maintain price stability – Bitcoin is highly volatile and in a deflationary cycle in that the prices of goods are falling in relation to the rapidly increasing price, so people naturally hoard it. Why buy a car for two Bitcoins today when it may only cost one Bitcoin in a short while?

For it to be classed as an asset, there needs to be some way to value it. There are no cashflows and no way that I know of to calculate its intrinsic value, except on the basis of future price appreciation (this is speculation not investment). Advocates argue fiat currencies are backed by nothing and have no intrinsic  value – the same can be said of Bitcoin.

As a payment mechanism, how is it any better than the hundreds of alternatives? If I want to send money to any place in the world I can do that already quickly and easily.

Is Bitcoin simply a new and easy way to speculate? Bitcoin enthusiasts will counter that this is an important innovation that could have important wide ranging applications so it is still cheap…

But Is The Future Really That Easy To Predict?

It is impossible to know for sure what the future holds for any new and potentially disruptive technology.  We can however reliably estimate that for every successful major discovery such as the Internet, DNA sequencing, antibiotics, radio and so on there must have been hundreds, perhaps thousands that never got off the ground. Therefore the likelihood of success is very improbable no matter how promising things may seem at first.

This is no great insight of course…

Venture capitalists and R&D departments understand that very, very few new discoveries will ever achieve commercial success and often the successful application is nothing like that first envisaged (the history of the Post-It is a great example).

The trouble is, we only hear of the few innovations that do well (the ‘survivor bias’). This badly skews us into thinking far more innovative ideas succeed than actually do.

So how come the price has risen so much so quickly?

Explaining The Rapid Price Rise Using Narratives…

Throughout history humans have passed on important messages as stories. The human mind is built for stories, especially stories about other human beings (in the case of Bitcoin it’s human beings gambling small amounts and making spectacular easy returns).

Narratives or stories have an epidemic quality to them, they are contagious. And so it is with Bitcoin. Robert Shiller, the Nobel prize winning economist, does a pretty good job of explaining this in the the following video:

Bitcoin is a tech story and technology stocks have done well recently (Amazon, Google, Facebook, Apple and so on..) so it fits into that narrative really well.

Several other factors make the Bitcoin story more contagious:

  • Mysterious story about the founder (nobody seems to know who he is or even if he exists). 
  • Conspiracy stories involving the banks, government, regulators etc. Apparently the ‘elites’ are scared of Bitcoin and want to regulate or stop it…
  • Disruption story – without working very much, earn supersize returns (15x in 2017 alone)… 
  • The story that Bitcoin has already has survived some crashes and therefore it will survive more in the future…
  • It’s complicated nature (very few understand how it actually works) lends social kudos to the believers. Bitcoin owners are smart. Ahead of the curve. Cool…
  • The early technology companies had a great story. Internet would change the world (it has) but few stopped to think how investors would fare along the way (badly). Investors paid a premium price today but the expected growth did not materialise…

These stories are spread very quickly from person to person via social media and other forms of social communication, fuelling demand even more.

Psychological And Other Factors That Have Driven Bitcoins Popularity (And Price)…

Envy jealousy – my favourite example is the ordinary guy on facebook who posts pictures of his $7m dollar Bitcoin account and asks people whether he should sell now or wait a while? Who could look at that and not feel a little bit envious? Envy/jealousy hits home even harder when friends and family are making easy money…

Anchoring – this is a well documented and scientifically established cognitive bias…
We overweigh events in the recent past and extrapolate short term trends and assume they will keep going – with Bitcoin that’s looking at recent price rises and anchoring on those, rather than thinking correctly about what tends to happen to technical innovations in general.

Scarcity – the fixed supply of Bitcoin is an argument for the continued price rises. Currently 16.7 million Bitcoin outstanding and mining will stop when total reaches 21 million in roughly 2140. More won’t be created but it has always been tempting for those in control of currency to print more of it. Bitcoin not guaranteed to be immune from this all too common and predictable evil (see book). Decent returns are also scarce in the current environment – some investors are so desperate they hand over millions without knowing where it will be invested (link).

Fear of missing out – people are making easy money and boasting about it on social media… You kick yourself for not buying in earlier… Then it keeps going up leading to more regret…

Affect heuristic is a mental shortcut that allows us to make decisions and solve problems quickly and efficiently, in which emotions —fear, pleasure, surprise, etc. —influence decisions. People generally ‘feel’ good about Bitcoin at the moment so they perceive the risks to be low and the benefits high.

Feedback loops – cool new technology… Early adopters… Price goes up. People talk about it. More people want it. Price rises… And so on (the rising price does all the marketing)… Nice video explanation:

AuthorityBitcoin futures now trade on a major exchange… Goldman Sachs is exploring a Bitcoin trading operation… Some retailers accept Bitcoin payments… It is worth reminding ourselves, many of these institutions exist to make money off people trading Bitcoin not Bitcoin itself (getting rich from selling picks and shovels to gold prospectors as opposed to prospecting themselves is a much less risky strategy…)

Confirmation bias – if you already ‘believe’ in Bitcoin then nothing I have said in this post will change your mind. You may even select some of what I have said and take that as an endorsement for Bitcoin investing. If you happen to be against, similarly you’ll look for evidence to support that belief. The trick is to try to keep an open mind and think objectively.

Scaling problem – many things work really well at small scale but fall apart when scaled. Using Bitcoin as a payment mechanism may work great for tech savvy millenials but that does not mean it will necessarily scale to the masses, given the regulations and controls that would need to be imposed.

And if you think people just don’t make important decisions without thinking things through thoroughly, it is worth reflecting that after the Brexit vote, the most popular search term on Google was “what is Brexit?

The tendencies I have listed above are deeply rooted in evolutionary psychology. They have kept us alive and helped us reproduce but in today’s world we are often led astray.

Conclusion

If I buy something and I make a lot of money did I make a good decision?

Not necessarily.

Lottery and casino winners make bad mathematical decisions (since the odds are usually clearly and heavily stacked against them) that turned out well due to luck. We do not think about all the players who also played but lost their money since they are not celebrating.

Conversely, I might have made a good decision even if I buy something and I lose money – if the odds and payoffs are clearly in my favour I should invest because more often than not I will win.

It’s impossible to come to an idea of the risks and payoffs related to Bitcoin because the following questions cannot be answered:

  • How would the Bitcoin market behave under stress. What are the future possible stresses?
  • What technologies could compete with Bitcoin?
  • What is the value of a Bitcoin (this is not the price). What is he correct valuation model? Is it robust and dependable?
  • Will Bitcoin likely still be around in 3 years? 5? 10?

The market for Bitcoin is relatively small, highly volatile and largely unregulated. It has attracted a lot of true believers and speculators. If many Bitcoin owners tried to sell at once the market will dry up and the price will crash. This is a common theme with mania’s gone by and when prices crash it is always dramatic.

As always I welcome debate. Please feel free to present your analysis. I would like to know how you think about the risks. What models you are using to think about this?

Parmdeep Vadesha

“The easiest thing of all is to deceive one’s self; for what a man wishes he generally believes to be true.” Demosthenes.

Comments

comments

6 thoughts on “Bitcoin: Is It A Bubble Or A Good Investment?

  1. I think you’re correct. Speculation is driving the BTC market not value. It’s behaving as many other bubbles have in the past only time will tell if it pops. Better to ride the wave trading forex than owning the coins themselves in my opinion. Having said that the spreads are huge and the volatility can take the shirt off your back as easily as make you profits. I’m standing back with a bag of popcorn for now.

    1. Great article, Parmdeep. Incisive, thorough, touches all the relevant bases.

      How can cryptocurrency have long-term scarcity value (which is crypto’s surrogate for intrinsic value)? Other cryptocurrencies, competing with bitcoin, have been and will no doubt continue to be set up, thus inflating the supply of cryptocurrency.

      It seems to me that bitcoin can only hold its value long-term if one or more of the following apply:

      – there are high barriers to entry i.e.it’s hard for competing cryptocurrencies to be set up

      – bitcoin has a USP (Unique Selling Point) compared with other existing or potential CRYPTOcurrencies (i.e. not just compared with ordinary currencies)

      – bitcoin has an enduring first mover advantage

      I for one would need a lot of convincing that any of the above do in fact apply.

      1. Hi Mike,

        How about the creation of more bitcoin? It’s theoretically not possible, but surely it just becomes too irresistible…

  2. “And you know something is happening, and you don’t know what it is. Do you, Mr Jones.”

    I hear what you say Parmdeep, and all of your points make sense, but, honestly, you seem to be writing from your own emotional position rather than any real objective analysis.

    That’s because objective analysis of this is impossible. Many experts on both sides of the argument can talk for days about why their position is more right than any other.

    I could find you many counter arguments, and they’d mostly come from people who arguably have less of an entrenched position in the old paradigm.

    But a discussion like that would run and run, and be, I believe, pointless – there is one thing and one thing only that matters in all this: no-one knows what’s going to happen.

    Really seriously, no-one knows.

    We can turn to our best technical analyses, history, previous bubbles – but the technological breakthroughs in the wider blockchain field that are going on have astonishing implications, and adoption is forging ahead.

    What is clear is that some kind of deep shift going on, to the point that it’s hard to see that the investment into the wider crypto-currency field is going to go away completely. On the other hand, anything could happen. Without a doubt, the whole area is currently in a state of mania, is a giant trap for the unwary, and re-mortgaging your house to buy crypto-currencies is beyond foolish.

    But playing with money you won’t miss, to see if you can make some money in the mania? That’s different.

    There will be winners in this, and without any doubt, new millionaires will be created this year. But anyone who thinks they know which crypto ideas that will do that is fooling themself and gambling, pure and simple.

    I’ve never been a gambling man, and yet, when the gamble is so asymmetric, when the potential upside is SO huge, it feels to me to make far more sense to have a small position in the game than not.

    Betting everything on Bitcoin feels foolish, I agree. But would you be damaged more by losing some money you wouldn’t miss, such as £5k, spread out at £200 positions on each of the top 25 crypto-currencies?

    There are three possible outcomes:

    1. The whole thing collapses, and you lose the lost.

    2. The whole thing drags on sideways for a few years, you get bored, pull your initial investment out, or most of it, and walk away with a little opportunity cost on other, ‘safer’ investments.

    3. 70% of your picks crash out completely, but five experience 500% growth over the next three years – and two go through the roof with 50,000% increases.

    Any of those three is possible, and no-one has a clue which it’s going to be.

    So it then becomes a matter of which side of the gamble makes more sense.

    I’ll personally get over losing £5k, but I’ll kick myself for a decade if I see those top 25 currencies going through explosive value hikes over the next five years.

    Count me in, for a small, diversified, stake. I feel I’d be crazy not to.

    1. Thank you for commenting Lee. You have a different view point and it’s great that you have laid out your thinking.

      You said ‘objective analysis of this is impossible’ and I would agree with you. That would make valuation impossible also. Therefore, I wrote this post to warn people seeking an investment opportunity that bitcoin is nothing of the sort.

      Blockchain may change the world in all sorts of ways we cannot currently foresee, but even if that were so, it does not mean owners of bitcoin will make money. Cars, aeroplanes, radio, internet etc were/are revolutionary but how did the owners (shareholders) fare on average across all companies? They did badly because so many promising business went out of business or they paid too much to get in.

      If you have the money to gamble with, and it’s a gamble that you think has a very large pay off then fair enough, what you do with your money is up to you.

  3. I personally invested/gambled sure me ££into ripple on EToro platform(~430% profits at the moment).
    My attitude to it is as per Lee post.Dont mind to loose it ,but at the same time in 3-5 years It can give me substantiall profit.
    The future is unpredictable:expect the worse and hope for the best.

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